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October 18, 2012

No Alpha: Evensky’s New Research Delivers Fresh Blow to Actively Managed Funds

New research published in a journal for fund managers deals a fresh blow to the idea that fund managers’ skill in actively managing portfolios can overcome the costs of their services in comparison with passively managed, low-cost index funds.

The study, published in the new issue of the Journal of Investing, examined 20 years of mutual fund performance data, tracking expansions and recessions both separately and collectively. Shaun Pfeiffer, a professor at Edinboro University in Pennsylvania and Harold Evensky, president of financial planning firm Evensky & Katz but also a professor at Texas Tech University in Lubbock, authored the study in the peer-reviewed finance journal.

The two researchers wanted to test the notion abroad that actively managed funds earn their keep through their outperformance in bear markets. The idea is that active managers can make defensive moves to protect a portfolio and preserve investor capital while passive index funds are prey to falling stock prices.

The academic research literature has been unkind to active fund management. Numerous studies, cited by Pfeiffer and Evensky (left), find actively managed funds’ average underperformance net of fees to be about 9% over a 10-year period.

The two researchers found that active fund managers do indeed perform better in recessions than in expansions. While their performance in recessions is enough to overcome their higher fees, active managers underperform passive strategies in periods of expansion and over investment horizons encompassing both expansion and recession.

Looked at more closely, though, the case for active management is further weakened by both the wide variance among actively managed portfolios and the lack of persistence across business cycles. While the top decile of actively managed funds generated significant alpha, the bottom-decile funds performed poorly.

“Collectively, these results show that there is more risk (i.e., variability and downside exposure) in performance across recessions and that risk-adjusted alpha for the worst performers in recessions is significantly more negative than that for the worst performers in expansions,” the authors observe.

Pfeiffer and Evensky also find that actively managed funds fall short in terms of “persistence of returns.” As a group, funds that have performed well in a recession tend not to deliver repeat performances whether from recession to expansion or recession to recession.

So while considering performance alone, actively managed funds may appear to cover their costs during times of recession, their lack of persistence would seem to yield little advantage to investors.

Still, Pfeiffer and Evensky leave open to further investigation questions about the characteristics possessed by the small segment of active managers that do generate alpha and are able to repeat their performance across business cycles.